What Traders Hope For—and Fear— in DC 'Fiscal Cliff' Talks

Wall Street's bull stands between Washington and the "fiscal cliff," and traders increasingly fear it will get run over.

Stocks have sold off more than 5 percent since election day on concerns that President Barack Obama and a divided Congress will not be able to strike a deal on taxes and spending that would avoid the U.S. economy hitting the $600 billion cliff. The cliff is a combination of taxes and automatic spending cuts that start to take effect Jan. 1 if Congress does not act.

While there has been talk from each side about a commitment to compromise, the first face-to-face meeting on the topic since the election takes place Friday when Congressional leaders meet with Obama at the White House. There is a lot at stake, and traders will be watching and waiting to see how Congressional leaders leave the meeting.

"It could go either way. I don't know that anyone has any fantastic visibility of what's going to come out of the meeting," said Gina Martin Adams, head of institutional equity strategy at Wells Fargo Securities. "We kind of have to wait for the results and see where we go from there."

The Dow slipped 28 points Thursday to 12,542, and the S&P 500 was down 2 at 1353. As stocks have sold off, money has moved into Treasurys, driving rates to the lowest level since early September. Small cap stocks and momentum names have been harder hit, with the Russell down 7 percent since election night.

"So far, we've heard really nice things compared to what's likely to unfold before the end of the year," said Zane Brown, fixed income strategist at Lord Abbett. "I still think nothing's going to get done until the end of the year. I think we're in for a very ugly period of volatility."

The Congressional Budget Office predicts a first half recession next year if the economy hits the cliff. It expects growth to be cut by a half percent for the year, and it expects growth to resume in the second half. But many private forecasts see a worse outcome if the full cliff is realized, and the unknown is how businesses and economic activity will respond to the process in Washington. If there is acrimony and contentious grandstanding, like during the debt ceiling debate, the hit on the economy could be even bigger.

The stock selloff is being fueled in part by the expectation that capital gains taxes are likely to rise next year. Capital gains rates could rise from 15 percent to 20 percent, or 23.8 percent for the wealthiest tax payers if tax breaks expire.

Particularly slammed has been Apple, the favorite stock in many a portfolio and fund, and a ripe target for tax loss selling, or capital gains avoidance in future years. The stock is down about 25 percent but still up 30 percent year to date.

Stocks that pay dividends, like utilities, have been thrown out for fear they will be less valuable if their dividends are taxed at a new higher rate. That rate could rise to as high as 43.4 percent for the richest taxpayers if the Bush-era 15 percent rate is left to expire.

"The dividend taxation issue is my greatest fear because I don't really know how you react to dividend taxes going to 45 percent and capital gains going close to 25," Adams said, adding investors have not had to consider those factors for years.

The market sell off also comes at the tail end of a lackluster earnings season, with a lot of disappointment and many warnings for the fourth quarter. Companies have pulled back on spending, and are signaling they will continue to hold off. For that reason, Adams said she downgraded tech stocks to underweight.

"Not only are investors selling their lack-of-conviction names, but they're selling their winners as well. That reflects that the market environment has turned significantly more negative," said Adams.

"The combination of fundamentals and technicals are already working against the market," she said. "If policy makers can't swoop in to add a boost to confidence, they're only going to add to the pressures...the problem now is this policy overhang is having real economic impact."

As investors take profits out of stocks, they have also been rushing into municipal bond funds because of their tax free status, and that has created a hot market for new issuance and record low rates. The MMD 10-year generic AAA muni was trading at 1.53 percent Thursday. According to Lipper U.S. Fund Flows, $3.3 billion left equity funds and ETFs in the week ending Thursday. Of that, $3 billion was taken out of the S&P 500 ETF SPY. That compares to inflows of $4.9 billion into equities last week, including about $4 billion into the ETF. (Read more: Why Muni Bonds Are Suddenly So Popular With Investors.)

Municipal bond funds received $706 million in the past week, on top of $866 million last week, unusually high volumes.

Issuers have benefited. "Deals are just getting completely eaten up. It's like they're never going to come again," said John Donovan, head of muni trading at Cantor Fitzgerald. He said in the past two days deals such as a $600 million Minnesota general obligation bond; a $590 million Texas transportation deal and $800 million in Hawaiian general obligation bonds were all oversubscribed.

Meanwhile, the public debate this week between the White House and House Republicans has been polite but shows a chasm in thinking about how to tax the rich. Both sides say they will be willing to bend, but Obama has stood his ground on higher tax rates, and House Speaker John Boehner has said higher revenues are possible but not higher rates. Comments from Obama sent stocks lower Wednesday, after traders took his re at a press briefing as a hardening of his position.

Source: Warner Bros.

"If these guys don't get their act together, the market's going down. The economy is going down. The global economy is going down, and the only place to hide is in long duration Treasurys," said Richard Bernstein, CEO of Richard Bernstein Capital Management. "They realize it's not in their interests to completely go over the cliff. All they have to do is come up with wording so that both sides can save face with the home constituencies."

What has not been a big part of the public discussion this week was a plan on spending cuts, about $100 billion of which are automatic and the result of the debt ceiling compromise in 2011. Half the spending cuts hit defense, and were intentionally made to be onerous so it would force Congress to act. Most of the rhetoric has been about tax rates, and not about the thorny issue of cuts to entitlement programs.

"The market's going to be unsettled until we get some clarity on this stuff that could be a matter of days, a matter of weeks, it could be a matter of months," said Bernstein. He said he has become more defensively positioned and favors consumer staples and health care. Bernstein said he likes consumer-oriented stocks since household balance sheets have been improving, along with housing.

Adams said she is hoping to see the market bottom sometime in the next six months, and she too recommends defensive positioning. "At some point, we'll get some fiscal policy and all these uncertainties end...I still think the U.S. economy has investable trends, but it's hard to see them right now," she said.

"The problem in Washington is it's all emotion. It could be at the one yard line, and somebody could get mad and walk out," he said, but added that's not likely this time. "The market will absolutely get destroyed, and in this environment, nobody's going to walk away because they don't want to be the one to walk away."